What To Do with REITs Now

The markets have seen a lot of changes, but changes aren’t required in our Managed Portfolios. We were well-positioned for the turn in interest rates. Let’s get right into the specifics.

Sector and Balanced Managed Portfolios

Real estate investment trusts saw the most action in the last month.

Cohen & Steers Realty Shares was up 13% for the year on April 1, following a 37% return in 2003. Then the decline began. The fund lost 9% in three days of trading ending April 6. It continued to decline, losing over 12% for the month by April 15. It gave up all its gains for the year and then some, leaving it down 2% since Dec. 31. The REIT indexes actually decline even more.

Several factors caused this across the board, unprecedented decline in REITs.

Several prominent REIT analysts simultaneously issued warnings that REITs were fully valued to overvalued and should be avoided. The first and most prominent warning came from Green Street Advisors in Barron’s. Some brokerage analysts followed suit. Their clients acted on this advice and sold REITs.

Higher interest rates were another factor. A number of investors purchased the highest yielding REITs over the last few years without regard to other qualities. Those investors sold their REITs along with bonds, believing the REITs would act like bonds when rates rose.

While disappointing, the recent decline in REITs doesn’t worry me or cause me to recommend a sale or reduction.

Longer-term, REITs do not perform like bonds and are not particularly hurt by high interest rates. The real estate underlying REITs is inflation protection, and dividends will increase as the economy grows. The investors who purchased REITs as bond substitutes now are largely out of the market, so the historic behavior of REITs should return. CSRSX declined less than the REIT indexes because it keeps a sharp eye on value and did not hold the highest-yielding REITs, which also tend to have the weakest fundamentals.

Stronger economic growth is good for REITs. As I’ve said in past visits, as economic growth picks up vacancy rates should decline, rents should increase, and property values should increase. In fact, the REIT decline followed a series of reports indicating that vacancy rates are declining in key property markets. There were no new reports of REITs or property markets in distress.

If REITs were overvalued to fairly valued in March, they are bargains now. The decline in April condensed almost a full bear market into one month. Prices declined while the fundamentals were improving. In addition, the price decline means yields for new investors are higher. To be a REIT bear now, you have to believe that the Fed will increase interest rates fast enough and high enough to sink the economy.

Hold your Cohen & Steers Realty Shares. If you don’t own REITs, this is a good time to start.

The rest of the recommended holdings have done well in the recent turbulence.

TCW Galileo Select Equity came back well after the correction and is up about 3% for the year. It is in the fast-moving sector of the markets and must be watched. I’m maintaining a sell signal on page 10. Hussman Strategic Growth is beating the market indexes, steadily climbing about 4% so far this year. Its policy of staying fully invested while hedging with options continues to work.

Driehaus Emerging Markets Growth is doing as expected. It rises faster than U.S. indexes when those indexes rise and falls more than the U.S. indexes on down days. If the U.S. markets and economy improved as expected, DREGX should rise further.

The only real disappointment in the portfolios so far this year is American Century International Bond. The dollar decline was due for a brief correction, and the prospect of higher U.S. interest rates strengthened the dollar. I expect the dollar to resume a decline as the year goes on.

Hold all positions in these Managed Portfolios. Only TCW Galileo Select Equity has a sell signal on page 10. Other funds should be held until I issue a sell order in the newsletter.

Income and Income Growth Managed Portfolios

We were a little early anticipating the rise in interest rates, but it is better to be early than to get caught a whipsaw like that of the last month.

Our largest position in these Managed Portfolios, Vanguard Short-Term Corporate Bond, declined less than 2%. That is well ahead of intermediate bond funds and bond indexes. In addition, as its short-term bonds mature the principal will be re-invested in higher-yielding bonds. Intermediate term bond funds must wait longer for their bonds to mature or sell them at losses. The fund should be held. When interest rates seem to be peaking, we’ll move into less conservative income investments.

Vanguard Inflation Protected Securities declined more than the indexes in the last month, giving up some of the excess gains I warned about last month. VIPSX still has a strong gain for the year and should be held, but it is not quite cheap enough for new investments.

Dodge & Cox Balanced, with its combination of value stocks and corporate bonds, is a nice counterbalance to the other funds. It is leading the Income Growth Managed Portfolio so far this year. Hold this fund.

I commented on Cohen & Steers Realty Shares in the section on the Sector and Balanced Managed Portfolios. Hold this fund.

There are no recommended changes in the Core Portfolios this month. Details of the portfolio recommendations are on page 10.